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Annuities

Annuities are widely-used investment tools available in a variety of types.

Annuities are a long-term investment product. [©Shutterstock, 2010]
©Shutterstock, 2010
Annuities are a long-term investment product.

Annuities

Annuities are a popular long-term investment product. Unlike other traditional investments, such as stocks and bonds, an annuity is a contract between an individual investor and an insurance company. The investor gives the insurance company money in either a lump sum or separate installments, and the company agrees to repay the investor with periodic payments. Depending on the terms of the annuity, the insurer may begin repaying the investor immediately or at a designated future time. Typically, money placed in annuities also grows tax-deferred until the investor begins making withdrawals, making them a popular financial product among investors planning for retirement. Also, because they may grow indefinitely, annuities prevent investors from outliving their assets. Although there are many types of annuities, they are usually categorized as fixed or variable.

Fixed Annuities

Fixed annuities are the financial instrument of choice for conservative investors interested in growing their assets over a long period of time. In return for an investment, the insurer agrees to provide a fixed rate of interest for that investment over a predetermined period of time. This is helpful because it protects the investor's money from changing interest rates and market volatility that may affect its growth. In addition to guaranteeing a fixed interest rate, the insurer agrees to pay the investor a minimum amount for each dollar in the account, increasing the annuity's reliability. In general, insurance companies with good claims paying ability and reliable financial performance offer the best rates for fixed annuities.

An important aspect of fixed annuities, especially when they are the primary source of retirement income, is the guaranteed lifetime income option. This option is similar to a pension or defined benefit plan in that it ensures the investor a steady stream of income until his or her death, but it offers the added benefit of tax-deferred earnings growth. Insurers can afford to offer this option because not all investors live to be the same age. The money not used by investors who die earlier than the company expects offsets the money used by investors who live longer.

Variable Annuities

Like fixed annuities, variable annuities are contracts between investors and insurance companies that produce tax-deferred earnings until the funds are withdrawn. Investors may choose to receive income for a definite period, such as 15 years, or for a lifetime. Unlike fixed annuities, which rely on the insuring company's claims paying ability and overall financial health, variable annuities rely on the performance of the financial markets in which their assets are invested.

As outlined by the U.S. Securities and Exchange Commission, money placed in a variable annuity is used to create a portfolio of other, more potentially profitable investments, such as stocks, bonds or mutual funds. For investors, the variable annuity's main benefit is its potential for both short and long-term growth. Provided that the annuity's assets are carefully managed, the potential for the accumulation of tax-deferred earnings will be much higher than that of a comparable fixed annuity. Of course, this variability also carries a much higher risk of financial loss failure to gain value or even lose value as the market declines. Some variable annuities do limit the amount that the investment can decrease over a certain timeframe, such as one year. Many variable annuities also carry surrender penalties which charge investors for early withdrawals. For these reasons, many people invest in variable annuities only after they have exhausted other, more reliable investment options, such as 401(k) plans and IRAs.

The Death Benefit

Another unique feature of variable annuities is the so-called death benefit, which provides for the transfer of an annuity's assets to a predetermined beneficiary upon the investor's death. According to the Insurance Information Institute, one reason the death benefit is an attractive feature is because the transfer of funds avoids probate, meaning the assets will pass to the new owner without requiring additional legal procedures. This benefit gives peace of mind to people wishing to grow their assets until their death without having to worry about when they should withdraw the funds.

Choosing the Right Option

Investors should carefully consider the costs and benefits of placing money in an annuity before agreeing to a contract with a company. Some investors may find that neither fixed nor variable annuities offer them the right combination of earning potential and low risk to comfortably meet their long-term financial goals. Both forms of annuity are solid investment options, as long as investors are willing to endure market fluctuations in order to grow their assets.

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